Fixed Index Annuity

Tim Barton       Click here to email us.
ChFC, CASL, CLU

Understanding Annuities:
A Lesson in Indexed Annuities Part 2

Table of Contents

Indexing Methods
Indexed Annuity Income Phase
Annuity Income Options
How Are Indexed Annuities Taxed?
Important Information
Indexing Methods
Each indexing method generally contains preset combinations of features, which impact the potential growth of your annuity investment.

Annual Reset (or Rachet)

Index-linked interest is determined each year by comparing the index value at the end of the contract year with the index value at the start of the contract year. Interest is added to your annuity each year during the term. Any declines are ignored.

Advantages
  • Future decreases in the index will not affect interest already earned.
  • May credit more interest than other indexing methods when the index fluctuates up and down often during the term.
  • Any gain is locked in each year.
Disadvantages
  • May be combined with other features, such as averaging and lower cap rates, that work to limit the amount of interest credited each year.
  • The participation rate may change each year and generally be lower than that of other indexing methods.

High Water Mark

Looks at the index value at various points during the term, usually annual anniversaries. Interest is then based on the difference between the highest index value and the index value at the start of the term. Interest is credited at the end of the term. Advantages
  • May credit higher interest than other indexing methods if the index reaches a high point early or in the middle of the term and then drops off at the end of the term.
  • Provides some protection against declines in the index.
Disadvantages
  • Since interest is not credited until the end of the term, index-linked interest may not be paid if the annuity is surrendered before the end of the term.
  • May be combined with other features, such as lower cap and participation rates, that limit the amount of interest earned.

Point-to-Point

Compares the change in the index at two distinct times, such as the beginning and ending dates of the contract term.

Advantages
  • May be combined with other features, such as a higher cap rate or higher participation rate, which may result in a higher rate of interest being credited.
Disadvantages
  • Relies on a single point in time to determine interest, meaning that an earlier gain can be lost if the index decreases dramatically at or near the end of the term.
  • Since interest is not credited until the end of the term, index-linked interest may not be paid if the annuity is surrendered before the end of the term.
Indexed Annuity Income Phase
When you are ready to begin receiving income from an indexed annuity, you can select from a variety of options, including:

Lump Sum Distribution

You can surrender your indexed annuity and receive the entire value in a lump sum payment. This option requires that income tax be paid on the indexed annuity earnings in the year you receive them. In addition, a lump sum distribution does not solve the problem of outliving your retirement income.

Systematic Withdrawals

You can set up a systematic withdrawal plan, through which you receive a specified amount of money at regular intervals, such as $1,000 per month, until all assets have been withdrawn. With this option, you have the flexibility to change the payment schedule in the future. Since, for income tax purposes, earnings are considered withdrawn before principal, the likelihood is that the earlier withdrawals will be fully taxed at ordinary income tax rates. In addition, with this option there is no guarantee that you will not outlive your retirement income.

NOTE: A lump sum distribution or systematic withdrawals made prior to age 59-1/2 may be subject to a 10% federal tax penalty on the taxable amount of earnings withdrawn, unless one of the exceptions is met.

Annuitization

You convert the value of your indexed annuity into a lifetime income or into a stream of payments for a fixed period of time. As reviewed on page 10, there are a variety of annuity income options from which to select.

Other Options

Talk to your licensed financial adviser about other options that may be available in the indexed annuity contract you are considering.
Annuity Income Options
At retirement, annuity income can be structured in a variety of ways, enabling you to select the income option that best satisfies your unique needs. While you can surrender an indexed annuity and receive a lump-sum payment equal to the annuity value, many people elect to convert the annuity value into a stream of retirement income using one of these income options:

Life Income Option

  • Payments are made for as long as the annuitant is alive.
  • Payments cease at the annuitant’s death.
  • This option produces the maximum guaranteed* lifetime income.

Life Income with Period Certain Option

  • Payments are made for as long as the annuitant is alive.
  • If the annuitant dies before a specified number of payments have been received (e.g., 120 monthly payments), the remaining payments in the period certain are made to the beneficiary.

Life Income with Refund Guarantee Option

  • Payments are made for as long as the annuitant is alive.
  • If the annuitant dies before payments equal to all or a specified portion of the purchase price have been received, the beneficiary receives the balance of the payments, up to the refund guarantee* amount.

Joint-and-Survivor Option

  • This payout option covers two lives.
  • The same payment can be received for as long as either of the two annuitants is alive or, alternatively, at the death of the first annuitant, the payment to the surviving annuitant can be structured to reduce to a specified percentage (e.g., 75%) of the payment received while both annuitants were alive.
  • A joint-and-survivor payout can also include a period certain feature.

Period Certain Option (no guarantee of lifetime income)

  • Payments are made for a specified number of years, such as 10 years or 20 years.
  • Payments cease at the end of the period certain.
  • If annuitant dies before receiving all guaranteed* payments, the beneficiary will receive the remaining payments.

    * All guarantees are based on the claims-paying ability of the issuing company.

Flexibility

While these are the five basic annuity income options, some annuity contracts offer additional flexibility…ask your licensed financial adviser about contract features that may add flexibility to your use of an annuity to provide retirement income.
How Are Indexed Annuities Taxed?

During the Accumulation Phase:

  • Earnings credited on the funds in an indexed annuity are tax deferred, meaning that the earnings are not taxed while they remain in the annuity.
  • Withdrawals from an indexed annuity during the accumulation phase are treated as withdrawals of earnings to the extent that the cash value of the annuity exceeds the total premiums paid and are taxed as income in the year withdrawn. To the extent that a withdrawal exceeds any earnings, that portion of the withdrawal is considered a non-taxable return of principal.
  • In addition, a 10% penalty tax may be imposed on withdrawals made before age 59-1/2, unless certain conditions are met. The penalty tax is in addition to the regular income tax on the withdrawal.
  • If the annuitant dies during the accumulation phase, the death benefit of the indexed annuity is generally included in the annuitant’s estate, to the extent of the deceased annuitant’s proportional contribution to the annuity purchase price.

During the Income Phase:

  • The annuity purchase price is returned in equal income-tax-free amounts over the expected payment period (based on the annuitant’s life expectancy).
  • The portion of each payment in excess of the tax-free return of the purchase price is taxable in the year received.
  • In summary, a portion of each annuity payment is received income tax free and the balance is taxable as received.
  • At the annuitant’s death, the present value of any remaining annuity payments due is generally included in the annuitant’s estate, to the extent of the deceased annuitant’s proportional contribution to the annuity purchase price.
A professional tax advisor should be consulted for more detailed information on annuity taxation in your situation.
Important Information
The information, general principles and conclusions presented in this report are subject to local, state and federal laws and regulations, court cases and any revisions of same. While every care has been taken in the preparation of this report, neither VSA, L.P. nor The National Underwriter Company is engaged in providing legal, accounting, financial or other professional services. This report should not be used as a substitute for the professional advice of an attorney, accountant, or other qualified professional.

Annuity contracts contain exclusions, limitations, reductions of benefits and terms for keeping them in force. All contract guarantees are based on the claims-paying ability of the issuing insurance company. Consult with your licensed financial representative on how specific annuity contracts may work for you in your particular situation. Your licensed financial representative will also provide you with costs and complete details about specific annuity contracts recommended to meet your specific needs and financial objectives.

NOTE: This annuity discussion is intended primarily to provide information on personal, non-qualified annuities that are not purchased to fund an IRA or qualified employer-sponsored retirement plan. An annuity purchased to fund an IRA or qualified employer-sponsored retirement plan does not provide any additional tax deferral, since tax deferral is provided by the IRA or qualified plan itself. If an annuity is purchased to fund an IRA or qualified employer-sponsored retirement plan, it should be done for the annuity features and benefits other than tax deferral. U.S. Treasury Circular 230 may require us to advise you that "any tax information provided in this document is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer. The tax information was written to support the promotion or marketing of the transaction(s) or matter(s) addressed and you should seek advice based on your particular circumstances from an independent tax advisor."

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